CAPITAL MARKET WORKSHOPS

1. CAPITAL MARKET WORKSHOPS • 1st Workshop – April 15th • “Overview of the Financial System”, Almir Mirica, executive director SASE • “The Role of Privatization in the development of the capital market”, Dr. Matej Živković, Securities Commission FBiH • 2nd Workshop – May 13th • “Sarajevo Stock Exchange – An Overview”, Dr. Tarik Kurbegović, CEO SASE • “Trading on the Sarajevo Stock Exchange”, Almir Mirica, executive director SASE • “Introduction to Valuation”, Feđa Krivošević, SASE • 3rd Workshop – May 27th • “Regulation of the Financial System”, Dr. Matej Živković, Securities Commission of FBiH • “Corporate Governance, Reporting & Disclosure”, Almir Mirica, executive director SASE • “Municipal Bonds”, Feđa Krivošević, SASE

2. Corporate Governance, Reporting & Disclosure Almir Mirica Executive director SASE

3. Contents • The Big Corporate Scandals • What is Corporate Governance? • Differences in Corporate Governance Regimes • OECD Principles of Corporate Governance • What is Disclosure? • Importance of Disclosure for investors, issuers and the economy • Documents of Disclosure • Importance of non-financial information • Corporate Governance, Transparency and Disclosure in the Federation of Bosnia-Herzegovina “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

4. Enron Corp., 2001. • American energy company, founded in 1985 in Houston, Texas, by Keneth Lay. 7th largets company in the US ranked by revenue. • Filed for bankruptcy after severe malpractices in accounting procedures went public; biggest bankruptcy (until then) in US-history and biggest audit failure • Share price went down from 90$ in mid-2000 to under 1$ in November 2001 • Brought down Arthur Andersen, the 5th largest audit and accounting partnership in the world, who were their auditor • By using accounting loopholes, special purpose entitites and poor financial reporting Enron managed to hide billions of $ of debt from failed deals and projects • Primary motivation for Enron’s accounting and financial transactions was to keep reported income and cash-flow up, asset values inflated, and liabilities of the book (through SPV’s) • Special Purpose Entity/Vehicle: limited partnership or company created to fulfil a temporary or specific purpose. Enron’s SPV’s were called JEDI, Chewco, Whitewing, Raptors...Primary use: keep debt of Enron’s balance sheet • Why? Focus on short-term earnings to maximize management bonuses “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

5. WorldCom, 2002 (now: MCI) • Telecommunications giant; 2nd largest long-distance telephone company in US (after AT&T) • Problem: Slowing-down of the main telecom-business and need to finance their other business endeavors (yachting, timber) threatened the share price (and management bonuses) • Solution: “cook the books”: Declining financial condition was masked by falsely professing financial growth and profitability • Normal operating expenses (line costs, i.e. interconnection expenses with other telecom-companies) were treated as investments and recorded over a number of years • In total, 3,8 billion US-$ worth of expenses were “capitalized”, leading to a net profit in 2001 of 1,3 billion US-$ • 2003 estimation: Companie’s total assets were inflated by 11 billion US-$ • July 21, 2002, WorldCom filed for Chapter 11 Bankruptcy protection • Largest bankruptcy in US-history (until Lehman Brothers in 2008) • Share price went down from 60$ to under 20 Cents. • In 2005, CEO Bernard Ebbers was sentenced to 25 years in prison. Bernard Ebbers, WorldCom CEO “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

6. Tyco International, 2002 • Tyco Int., Swiss-based electronic-components manufacturer, health care and safety equipment. • CEO Dennis Kozlowski • Business Week 2002: One of the Top 25 corporate managers in USA • Kozlowski received (or took?) 170 million US-$ in low-or no interest loans from Tyco, without shareholder approval • Kozlowski arranged the selling of 7,5 million of unauthorized shares of Tyco, receiving 430 million US-$ • As the news came out in early 2002, share price decreased 80% in just 6 weeks • During the (first) trial, much focus on his shower curtain (6.000 $) and wife’s 2 million US-$ birthday party on Sardinia • On second trial in 2005: convicted of grand larceny, conspiracy, and fraud, and sentenced to 8 and 1/3rd years to 25 years “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

7. What do they have in common? Interests of shareholders (owners) ≠ Interests of managment “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

8. What is Corporate Governance? • Renewed interest regarding CG after the big corporate scandals in the beginning of 2000’s – Enron, WorldCom, Tyco, Parmalat... • Corporate Governance (CG) is often confused with the issue of ethics or ethical behaviour • Although ethical behaviour is expected from all the actors in CG process, CG at its core is about the characteristics of a governing process and not about a particular behavioral trait. • Definitions of CG: • Corporate governance is the framework of laws, rules, and procedures that regulate the interactions and relationships between the providers of capital (owners), the governing body (the board or boards in the two-tier system), seniors managers and other parties that take part to varying degrees in the decision making process and are impacted by the company’s dispositions and business activities. Corporate governance defines their respective roles and responsibilities and their influence in steering the course of the company. (Miguel A. Mendez) • “The relationship among various participants in determining the direction and performance of corporations” (California Public Employees' Retirement System – CalPERS) “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

9. Differences in CG Regimes • CG is needed as a result of the seperation between the ownership and managment function in modern corporations • CG does not occur in a vacuum. • It reflects the economic, historical, cultural and legal characteristics of a country, it’s business history and corporate landscape • It is also shaped by the ownership structures...and by the financing options available to businesses. • Differences in these areas account for some of the notable differences in the governance models found on either side of the Atlantic. • Characteristic for the United States • High dispersion of ownership (and thus voting power) weakens the ownership/control link  gives managers great power, who are tempted to use it for their sole benefit • Monitoring must focus on alligning the interest of the management with the interests of the shareholders (owners) • Characteristic for Europe (except UK) • Blockholders have significant voting power over the dispersed minority owners (who together may have the majority of ownership!)  incentives for blockholders to exercise monitoring of managment, but also to extract benefits for themselves (but not for the rest of the owners) • Monitoring must focus on insuring that large voting blockholders look after the interest of all shareholders, not merely their own. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

10. OECD Principles of Corporate Governance • “Organisation of Economic Co-Operation and Development” (OECD) • 1999: Definition of 6 Principles on Corporate Governance • 2004: Revision of Principles • Principles: • I - Ensuring the Basis for an Effective Corporate Governance Framework • The corporate governance framework should be developed with a view to its impact on overall economic performance, market integrity and the incentives it creates for market participants and the promotion of transparent and efficient markets. • The legal and regulatory requirements that affect corporate governance practices in a jurisdiction should be consistent with the rule of law, transparent and enforceable. • The division of responsibilities among different authorities in a jurisdiction should be clearly articulated and ensure that the public interest is served. • Supervisory, regulatory and enforcement authorities should have the authority, integrity and resources to fulfil their duties in a professional and objective manner. Moreover, their rulings should be timely, transparent and fully explained. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

11. OECD Principles II – The Rights of Shareholders and Key Ownership Functions A - Basic shareholder rights should include the right to: 1) secure methods of ownership registration; 2) convey or transfer shares; 3) obtain relevant and material information on the corporation on a timely and regular basis; 4) participate and vote in general shareholder meetings; 5) elect and remove members of the board; and 6) share in the profits of the corporation. B - Shareholders should have the right to participate in, and to be sufficiently informed on, decisions concerning fundamental corporate changes... C - Shareholders should have the opportunity to participate effectively and vote in general shareholder meetings and should be informed of the rules, including voting procedures, that govern general shareholder meetings (date,location and agenda of meetings, full information about the agenda items; should have opportunity to ask questions to the board...) D - Capital structures and arrangements that enable certain shareholders to obtain a degree of control disproportionate to their equity ownership should be disclosed (ie cross-shareholdings) E - Markets for corporate control should be allowed to function in an efficient and transparent manner (i.e. take-over procedures) F - The exercise of ownership rights by all shareholders, including institutional investors, should be facilitated. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

12. OECD Principles III – The Equitable Treatment of Shareholders A - All shareholders of the same series of a class should be treated equally. B – Insider trading and abusive self-dealing should be prohibited. C – Members of the board and key executives should be required to disclose to the board whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation. IV - The Role of Stakeholders in CG A - The rights of stakeholders that are established by law or through mutual agreements are to be respected. B - Where stakeholder interests are protected by law, stakeholders should have the opportunity to obtain effective redress for violation of their rights. C - Performance-enhancing mechanisms for employee participation should be permitted to develop. D - Where stakeholders participate in the corporate governance process, they should have access to relevant, sufficient and reliable information on a timely and regular basis. E - Stakeholders, including individual employees and their representative bodies, should be able to freely communicate their concerns about illegal or unethical practices to the board and their rights should not be compromised for doing this. F - The corporate governance framework should be complemented by an effective, efficient insolvency framework and by effective enforcement of creditor rights. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

13. OECD Principles V – Disclosure and Transparency VI – Responsibilities of the Board A - Board members should act on a fully informed basis, in good faith, with due diligence and care, and in the best interest of the company and the shareholders. B - Where board decisions may affect different shareholder groups differently, the board should treat all shareholders fairly. C - The board should apply high ethical standards. It should take into account the interests of stakeholders. D - The board should fulfil certain key functions, including: 1. Reviewing and guiding corporate strategy, major plans of action, risk policy, annual budgets and business plans; setting performance objectives; monitoring implementation and corporate performance; and overseeing major capital expenditures, acquisitions and divestitures. 2. Monitoring the effectiveness of the company’s governance practices and making changes as needed. 3. Selecting, compensating, monitoring and, when necessary, replacing key executives and overseeing succession planning. 4. Aligning key executive and board remuneration with the longer term interests of the company and its shareholders. 5. Ensuring a formal and transparent board nomination and election process. 6. Monitoring and managing potential conflicts of interest of management, board members and shareholders, including misuse of corporate assets and abuse in related party transactions. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

14. What is Disclosure? • Transparency: “letting the information be available” • Information disclosure: publication of information regarding the business operations of a company; “disclosure”; “reporting” • Process through which companies inform the market about their business operations • Materiality of information (OECD): • “Material information can be defined as information whose omission or misstatement could influence the economic decisions taken by users of information. • Classification of disclosure • Financial vs. Non-financial information • One-time (prospect) vs continuous disclosure (periodic financial reports) • National legislation prescribes the minimum disclosure level • CG Codes and other “soft laws” advance the disclosure level • International standards which define disclosure requirements • OECD i IOSCO “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

15. OECD Principle V • OECD CG Principles - Principle V (2004): “Disclosure and Transparency” • A – Disclosure should include, but not be limited to material information on: • Financial and operating result of the company • Company objectives • Major share ownership and voting rights • Renumeration policy of board members and key executives • Related party transactions • Foreseeable risk factors • Issues regarding employees and other stakeholders • Governance structures and policies • B – Information should be prepared and disclosed in accordance with high quality standards of accounting and financial and non-financial disclosure “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

16. OECD Principle V C - An annual audit should be conducted by an independent, competent and qualified, auditor in order to provide an external and objective assurance to the board and shareholders that the financial statements fairly represent the financial position and performance of the company in all material respects. D - External auditors should be accountable to the shareholders and owe a duty to the company to exercise due professional care in the conduct of the audit. E - Channels for disseminating information should provide for equal, timely and cost-efficient access to relevant information by users. F - The corporate governance framework should be complemented by an effective approach that addresses and promotes the provision of analysis or advice by analysts, brokers, rating agencies and others, that is relevant to decisions by investors, free from material conflicts of interest that might compromise the integrity of their analysis or advice. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

17. Efficient Market Hypothesis • Theoretical foundation for importance of disclosure • Developed by prof. Eugene Fama (University of Chicago) as an academic concept in 1965; refined in 70’s • Theory about how securities are priced and about the question if anyone can (in the long run) outperform the market • Three forms of efficiency: • Weak form: examines whether securities prices fully reflect past information. If they do  technical analysis cannot be used to outperform the market • Semi-strong form: deals with publicly available information (financial statements and economic forecasts) and whether security prices fully reflect this information. If true, superior security returns cannot be achieved through fundamental analysis. • Strong form: security prices reflect all information. If true, even inside information (insider trading) won’t work for superior returns. • Until the beginning of the 90’s, EMH was the fundament of the theory of financial markets. • Today still influental, although heavily critized: • EMH says the “market is always right”: Really? • EMH assumes a majority of rational players on the market: Are humans really rational? • Whether EMH is right or not, the basis for any form of efficency is the availability of information about the issuers “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

18. Warren Buffet on market efficiency... “I’d be a bum on the street with a tin cup if the markets were efficient ... Investing in a market where people believe in efficiency is like playingbridge with someone who has been told it doesn’t do any good to look at the cards.” Warren Buffett “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

19. Importance of Disclosure DISCLOSURE IS IMPORTANT FOR: INVESTORS ECONOMY IN GENERAL ISSUERS “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

20. Importance for investors • During the investment decision: • Financial information: basis for all valuation models (fundamental valuation, ratio analysis etc) • Non-financial information: assesment of the overall business risks of the company (e.g. higher risk  higher required rate of return) • Special importance for company analysts and rating agencies • “Investing without research is like playing poker without looking at the cards.” (Peter Lynch) • Importance for shareholders • Without timely and accurate information about the business operations no control of the management is possible • How to exercise voting rights on the Shareholder’s Assembly without proper information? • Decreasing information assymetry between investors • Decreased risk for investors for trading with better-informed (inside) investors  information and transaction costs are reduced • Higher liquidity (and value) of company shares, which is important for the shareholders. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

21. Importance for the Economy • Information: “Lifeblood” of the capital markets • Lack of information  Lack of investors  Smaller liquidity, higher volatility higher market risk  higher risk premium required by investors  higher financing costs for issuers • If the market functions, the economy’s scarce resources are efficiently allocated • Strong transparent disclosure regime is pivotal for market-based monitoring of companies • Weak disclosure can contribute to unethical behaviour and loss of market integrity, costing not only company but economy as a whole. • Connection between the quality of the corporate governance regime and the economical development of the country • Robert M. Bushman i Abbi J. Smith : “Transparency, Financial Accounting Information and Corporate Governance” (2003) “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

22. Importance for issuers • Disclosure and reporting requirements are generally seen as an additional burden for the company • However, a transparent and pro-active approach to disclosure is in the interest of the company. • “Closed” company: • Difficult to gather capital through issuance of securities • Investors avoid investing in “black box” companies • Transparent, open company: • Ensures the critical mass of trust between the company and (potential) investors • Decreased costs of adverse selection increases the interest of investors  higher liquidity of the issuers securities • Higher liquidity decreases the costs of external financing • Price of security can be a control mechanism for the managment of the company • McKinsey’s Emerging Markets InvestorsOpinion Survey 2001: investors would pay a premium of up to 30% for a well governed, transparent company. • In B&H, most financing needs of companies are met by bank loans • Issuer still do not see the need for a more transparent approach vis-a-vis the investors “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

23. Documents of Disclosure • Annual Report • “Glossy Annual Report”, contains CEO message to shareholders; financial report with auditor’s opinion (internal and external auditor); information about the Supervisory Board and Managment Board members; overview of the operations of the company in the last year. • Periodic financial reports (annual, semi-annual and quarter-reports) • Balance sheet • Income statement • Cash-Flow Statement • Auditor’s Report • Managment Discussion and Analysis of financial condition and results of operations(MD&A) • Prosepectus • Required before issuing securities • Fundament for the investment decision • Contents defined by regulator and stock exchange • Price sensitive information (Ad Hoc Disclosure) • All information which can affect the price of the security (information which relates to the financial and legal position of the issuer, affects the capital structure etc.) • Disclosure in a way which treats all shareholders / investors equally “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

24. Importance of non-financial information • Company Book Value ≠ Company Market Value • Especially pronounced with “knowledge companies” • Baruch Lev (1996): Market value of average Wall Street company is 40% higher than its book value; high tech companies: more than 50% higher market valuation • Proof that the market values intangible assets • Traditional accounting cannot adequately quantify intangible assets • Double negative effect on the balance sheet • Intangible assets: rare verbal defintions; mainly defined through classifications 1. Leonard N. Stern School of Business: classification according to GAAP: - Narrow definition: “nonphysical sources of probable future economic benefits to an entity that have been acquired in an exchange or developed internally from identifiable cost, have a finite life, have market value apart from the entity, and are owned or controlled by the entity” “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

25. Importance of non-financial information • 6 classes of intangible assets • General: goodwill (e.g. beneficial relations with government – Goldman Sachs) • Brand equity: capacity of brands to sustain and encourage economic demand and other market capabilities such as advertising (e.g. Coca Cola) • Intellectual capital: including trade secrets, internally developed computer software, drawings; intellectual property (patents, trade names, trademarsk, copyrhights) • Structural capital: relationship with employees, leadership, organisational capacity... • Customer equity: customer lists and customer based intangibles, customer loyalty • Supplier relations: equity interest in suppliers, contracts... 2. Classification according to Roos et al (1997): Overall Value Financial Capital Intelectual Capital Human Capital Structural Capital “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

26. Corporate Governance, Transparency & Disclosure in the Federation of Bosnia-Herzegovina “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

27. Low adoption of CG Principles • The mass-privatization programm resulted very often in “insider entrenchment”, with limited or no changes in the managment practices • High information asymmetry is in their interest • Failure to maximise shareholders’ value • Modern principles of corporate governance are not widely adopted • Majority owners often fail to acknowledge the seperation of the ownership and the control function in the company • Independent members of Supervisory boards are rarely appointed • Members of the Supervisory boards represent the interests of those shareholderholder who appointed them • Profits are often not distributed to all shareholders, but extracted through affiliated companies; in extreme cases: asset stripping • State as an owner does not follow corporate governance principles • “We are the state” vs. State as majority shareholder • Dividends are first paid to majority owner (state), then to the rest?! “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

28. Ongoing battle for more transparency • “Socialist heritage”: Different function of financial reports in the socialist economy • Financial reports are often regarded as “top secret” • Fosters inside trading • Repels domestic and foreign investors • Low market liquidity • Unfavourable conditions for company development through the market • Until 2005: • Only the most persistent investors could get financial reports from companies • Legal obligation of issuers to submit their annual & semi-annual financial reports to the AFIP’s (Sarajevo and Mostar) in PAPER FORM • Ad-hoc informations has to be published in daily newspapers • 2005: • SASE signs commercial contract with AFIP’s in order to receive annual and semi-annual financial reports from the issuers and publish them on its web-site • SASE engages professional clipping-service and publishes ad-hoc information on its web-site • Many issuers fail to send their reports to AFIP or publish it in the newspapers “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

29. Ongoing battle for more transparency • 2007: • Securities Commission enacts Bylaw on information disclosure; requires more disclosure by companies • Low effects, as the Securites Law does not proscribe sanctions • Today • Issuers must publish their annual and semi-annual financial report in two ways: • Electronic,full form: deliver it to SEC and SASE • Short form: for publishing in daily newspapers, obliged to send publication proof to the SEC • Price-sensitive information must be published in daily newspapers and sent to the SEC and SASE • Result: Issuers either publish only the short form, only the electronic form, or they do not publish anything • September 2011: SASE delists 410 low-liquidity securities of non-transparent issuers from the market and enacts strict disclosure rules • Issuers who do not meet the disclosure requirements are demoted to the lower market sub-segment and eventually delisted from the market • SASE also created a disclosure manual for issuers, explaining them what is to be published at which time and distributed it to the issuers “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

30. Ongoing battle for more transparency • What are the reasons for the low transparency? • Lack of information: Issuer should, but do not know what their obligations are • Lack of sanctions for not disclosing information • High costs for preparing and publishing information • Starting from July 1st, 2013 • Last changes in Securities Market Law proscribe hefty penalties for lack of disclosure • New Disclosure Bylaw does not require publication in newspapers • Publication on company web-site AND on SASE web-site • Significant cost reduction for issuers • Streamlined publication procedures “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

31. Final words... • “Corporate Governance” is a process, not a state • On paper, Enron had a model board (“Chief Executive” magazine ranked it as one of the Top 5 Corporate Boards in the USA in 2000) • “If companies focus their thinking and communications on short-term results or short-term stock market consequenes they will, in large part, attract shareholders who focus on the same factors. And if they are cynical in their treatment of investors, eventually that cynicism is highly likely to be returned by the investment community” (Warren Buffett, CEO Berkshire Hathaway) • There is hope: Capital has no memory, it will flow where is sees reward and understands the risks “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013

32. THANK YOU FOR YOUR ATTENTION!

33. “CG, Reporting & Disclosure”, Almir Mirica International Burch University, May 27th, 2013